May 29, 2019 | Forbes

Stronger AML Enforcement Might Actually Save Crypto

May 29, 2019 | Forbes

Stronger AML Enforcement Might Actually Save Crypto

A backlash is brewing in the cryptocurrency business sector as financial authorities prepare to enforce regulations that directly challenge cryptocurrency technology’s pseudonymous and permissionless nature. However, this backlash is a sign that many in the crypto space are missing the bigger picture. Stronger regulations for anti-money laundering and countering the financing of terrorism (AML/CFT) are exactly what is needed if cryptocurrencies are to achieve mass adoption.

In late June, the Financial Action Task Force (FATF), an intergovernmental body that sets global AML/CFT standards, plans to finalize an update to its recommendations regarding new technologies in order to strengthen regulations on “virtual assets.” The most controversial part of the update is the instruction for virtual asset service providers (VASPs) to obtain the identity of both the sender and recipient of every virtual asset transaction they facilitate, similar to what banks must do with wire transfers. This is commonly referred to as the “travel rule” for transmittal of funds, a requirement that financial institutions have operated under for decades.

I highlighted this upcoming change back in March, assessing that cryptocurrency exchanges would have a hard time complying with these standards and that, if implemented, most cryptocurrency activity would eventually end up looking like conventional banking. In the months since, various groups in the crypto space have pushed back on FATF’s planned update. Some of the critiques are valid: VASPs certainly have no easy way to obtain the true identities of parties to a transaction when those parties use non-custodial wallets. Also, free cryptocurrency software is available to allow people to operate peer-to-peer and pseudonymously, outside the purview of VASP-controlled platforms. And perhaps most significant from an AML/CFT perspective, bad actors are likely to respond by moving toward unregulated environments, both geographically and in cyberspace. These new standards may force a relocation of illicit finance involving crypto, but they will not stop it.

However, there is another way to look at these stricter standards. They actually legitimize cryptocurrencies globally as a form of value transfer and set the stage for the conventional financial sector to use the technology, in line with established regulatory frameworks. Crucially, the U.S. government has signaled its support for this move toward legitimacy, although few in the crypto community have noticed.

U.S. Setting the Global Standards

The U.S. holds the current year-long presidency of FATF and stated at the beginning of its term that clarifying regulatory treatment of virtual currencies was a main objective. Not coincidentally, in early May, Treasury’s Financial Crime Enforcement Network (FinCEN), the agency that enforces AML/CFT regulations in the U.S., released a 30-page guidance document outlining how virtual currencies fit under its authorities. FinCEN wrote that its guidance served “to remind” persons about regulatory obligations and provide regulatory certainty, and that it was not presenting any new rules for the virtual asset sector. Yet, reading between the lines, it is apparent that FinCEN’s latest guidance represents a maturation of U.S. enforcement of the crypto space.

The new guidance explicitly states that cryptocurrency exchanges must comply with the travel rule. But that has always been the case; FinCEN confirmed that requirement in 2013 when it released its initial guidance clarifying that virtual currency exchangers must follow all the same rules as other money service businesses. Nonetheless, U.S. authorities have not enforced the travel rule for virtual asset transfers, probably because doing so would have stifled the development of the nascent cryptocurrency industry. So, for a full six years, cryptocurrency exchanges have been operating on a trial basis, not necessarily following all regulations to the letter.

It seems highly unlikely that FinCEN will refrain from enforcing the travel rule now that it has published its “reminder” and the U.S. has steered the international community to enforce the same obligations through FATF’s updated standards. This means the U.S. is welcoming the crypto space to join “the big league” of conventional finance if the crypto space will abide by the global rules.

This is an opportunity for the cryptocurrency sector.

The United States, the world’s leading financial power, has essentially authorized a global financial hackathon for blockchain technologists. The crypto space is being challenged to come up with new ways to integrate cryptocurrency payments into the global financial system. There is just one catch: Follow AML/CFT regulations.

Often, I brief major global banks on the benefits and risks of cryptocurrencies. I have found that most financial institutions do not want to touch crypto with a 10-foot pole, even if they acknowledge the theoretical advantages of distributed ledger technology. The only way many banks would consider servicing VASPs or even offering customers direct access to cryptocurrencies would be if they could wall themselves off from risks of pseudonymous transfers.

New Solutions will be Needed

The crypto space should figure out how to solve this problem. It may mean developing a system of digital wallets whose users have gone through AML and “Know Your Customer” procedures. Of course, there are technical, procedural, and privacy challenges in developing such a system. However, if sorted out, the prize could be mass adoption of cryptocurrencies, enabling them to compete with checks, bank wires, credit cards, and mobile money payments.

The complaint that these new standards will undermine the virtual asset industry are short-sighted and reflect a disconnect from reality. There never was any real possibility that regulators would endorse the mass scaling of pseudonymous digital payments. A world of ubiquitous internet money untethered to identity brings distinct dangers. Imagine “assassin-for-hire” markets no longer stifled by the risky and cumbersome payment methods currently available on the darknet. Consider what might happen if child trafficking rings can guarantee that all their financial transactions are never traced.

Free societies certainly allow the Internet to flourish even though it enables all types of illegal activity to spread. We allow encryption in the telecommunication sector although it helps terrorists hide their plotting. The benefits of these technologies clearly outweigh the inevitable criminal use. Digital financial value is different. Money is more than a tool. It incentivizes and rewards activity. The friction involved in moving millions or billions in illicit proceeds today hinders the scope of terrorist financing, nuclear proliferation, and even government corruption. Creating a world with uncapped secret digital payment channels would be opening a pandora’s box.

Cryptocurrency Privacy is Not Eliminated

It is important to note that cryptocurrency pseudonymity and even anonymity are not banned by FinCEN’s guidance or FATF’s standards. Anyone who understands blockchain technology knows that it is impossible in practical terms to stop the proliferation of privacy coins or other de-anonymizing open-source software. Such tools will continue to exist, just as TOR and virtual private networks exist to allow anyone to hide their identity online. The cypherpunk vision of anonymous peer-to-peer electronic payments is still available for the tiny minority who want it. But most people are not interested in that. Those who are, can transact anonymously, but on a small scale.

What these new standards do is put some guide rails on the growth of the cryptocurrency space. They are a call for more innovation and for developers and thought leaders in crypto to figure out how to manage this breakthrough technology so that it can promote liquidity, expand prosperity and financial inclusion, mitigate crime, and protect privacy. The technology will never gain widespread adoption unless these oft-conflicting aims are harmonized.

Cryptocurrency enthusiasts need to decide if they want this technology to be solely for a minority of ultra-libertarians and other ideologues who are willing to take the arduous steps currently needed to navigate the user-unfriendly crypto space. Or, do they want the broader public and merchants worldwide to start using cryptocurrencies? Regulators enforcing these AML/CFT standards will raise the bar for cryptocurrency businesses. But these higher standards may be precisely what helps the crypto space to mature.

Yaya J. Fanusie, a former CIA analyst, is an expert on cryptocurrency & national security. He is an adjunct fellow at the Foundation for Defense of Democracies, a Washington DC think tank.